The Fed in Focus

By Jennifer Marquand, 03/05/2010

"Provided for the establishment of Federal Reserve Banks, to furnish an elastic currency, to afford means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes."

- Federal Reserve Act, 1913

With the 2008 credit crisis hardly in the rearview mirror, many assume we face an entirely new set of insurmountable problems. Yet, since its inception, this country has been no stranger to financial panic. Thankfully, such crises have become increasingly rare and less devastating—thanks in part to the maturation of our own central bank, and central banks globally over the past several decades. So with plenty of proposals pending to "fix" our regulatory system to prevent future crisis, it's worthwhile to examine the origins of our current system. Not surprisingly, the Federal Reserve, a potent force to stem financial crises, was itself born of a panic.

In the Fall of 1907, financial fear was pervasive. After a failed corner by F. Augustus Heinze, the stock of United Copper Company dropped from $62 to $15 a share in just two days—spectacularly bankrupting the copper speculator. But the problem didn't end with one man's lost wealth—Heinze was also a bank investor and president of Mercantile National Bank. As news of his financial ruin spread, a number of New York bankers connected to him faced panicked depositors and bank runs. The New York Clearing House Committee (in charge of redeeming members' checks but also enforcing self-regulatory responsibilities) endeavored to gauge the solvency of and back member banks. But the panic was fast moving beyond the Clearing House's sphere as runs on a few large trust companies (not eligible for Clearing House membership) pushed them to the brink of failure.

Amid diminishing liquidity and escalating unrest, legendary American financier J. Pierpont Morgan stepped in. After numerous hasty closed-door meetings, Morgan threw together a rescue package of personal contributions (e.g. $10 million from John D. Rockefeller Sr.) and $25 million from the Treasury. Knickerbocker Trust was allowed to fail (after Morgan found its books lacking) but Trust Company of America was saved. Meanwhile, the panic spread to the stock exchange. Late in the afternoon of October 24, Morgan gathered prominent bank heads in his personal office. On his assurances that nearly 50 New York Stock Exchange houses would fall if they didn't immediately raise money, the bankers coughed up the dough—$25 million in 15 minutes—allowing the brokers to successfully settle their accounts.

The rest is history—the panic slowed but was accompanied by a steep recession (May 1907 to June 1908) as Wall Street limped back to life. This wasn't the first time a bank panic had significant economic impact—nor was it the worst such occurrence—but the Panic of 1907 proved a catalyst for change. Despite initial praise for J.P. Morgan and a few fellow prominent bankers, it became clear the panic had stretched their power, and calls for major modification of the nation's financial system resonated.

In 1910, Senator Nelson Aldrich of Rhode Island introduced legislation proposing the creation of a US central bank. A round of 1912 congressional hearings directed by House Representative Arsène Pujo and lead counsel Samuel Untermyer upped the urgency after finding Wall Street power dominated by just a few individuals—Morgan foremost of all. Signed into law by President Woodrow Wilson in late 1913, the Federal Reserve Act was drafted specifically to counteract this perceived power concentration among a "monetary elite" and "furnish an elastic currency" by establishing a regional reserve system to operate under a supervisory board in DC.

With a relatively vague mandate, the Fed was given freedom to fulfill its goals largely without political intervention. (Although this has never really been the case—political will has almost always wormed its way into decision-making.) The seven members of the Board of Governors are appointed by the president and confirmed by the Senate to serve single 14-year terms—ostensibly to prevent political influence while also providing some continuity. The president appoints a chairman and vice chairman from among the seven Board members—both four-year appointments also require Senate approval. The seven Board members, the head of the Federal Reserve Bank of New York, and four other regional reserve bank presidents make up the Federal Open Market Committee, the body responsible for setting the nation's monetary policy.

From reactionary monetary tightening and errant interest rate manipulation during the Great Depression to an inability to combat rampant inflation in the 1970s—the Fed's role, influence and capacity to hold the public's confidence have all waxed and waned. And the recent financial crisis was no different. Arguably, greater global coordination and better technology allows the Fed to test theory before enacting it to utter ruin—and the worst mistakes today are less damaging than they were just a few decades ago. But the Fed is now and will forever be prone to making some errors—even major ones. Investors must always be alert for this possibility.

With the worst of the credit crisis decidedly behind us and the global economy on the mend, the Fed's ongoing role will continue to be a hotly debated topic—some want to sharply rein in the central bank's powers (or abolish the institution altogether) while others are pushing to expand its scope. In either case the Fed isn't going anywhere any time soon—for better, for worse, for richer, for poorer. And while it certainly isn't a perfect system (what government creation is?) the Fed can and does provide a backstop for an economy on the brink (even if Fed errors themselves brought us to that brink)—a feat no JP Morgan could hope to accomplish alone in today's huge, complex, global economy.

*The content contained in this article represents only the opinions and viewpoints of the Fisher Investmentseditorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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